Deflation threat “clearly growing” even as Chinese stocks rally

Fresh data out of China shows that the world’s second-largest economy continues tip-toeing toward outright deflation, a condition that could make it even more difficult to shake off the long slump that set in amid Covid and shows little sign of lifting.

China’s consumer price index in September was just 0.4% compared to the prior year, a decline from the 0.6% rate in August. Its producer price index, a measure of prices of industrial products at the factory gate, continued to fall from last year’s levels, dropping 2.8% year over year.

Deflation, or falling prices, might sound like a good thing for Western consumers who’ve dealt with a bout of inflation over the last few years. But entrenched deflation — a broad-based decline in prices — can cripple economies, as it pushes virtually every economic actor to delay spending decisions in the hopes of paying lower prices in the future. That creates a feedback loop in which lower spending forces business to cut back production and lay off workers, leaving them even less likely to spend, forcing still more production cuts. And so on.

The traditional cure to such a situation is massive amounts of government spending aimed at boosting both economic activity and the morale of investors.

In recent weeks, signs that the Chinese government was on the brink of such a major spending spree resulted in a price explosion for Chinese stocks. In roughly two weeks, the benchmark mainland index, the CSI 300, soared about 40%. That’s a rally of size and scope that is unmatched in the entirety of US market history.

But on Saturday, a highly awaited news conference by a key Chinese economic official was light on details, offering only that there would be more "countercyclical measures" this year.

Stocks on the mainland managed to rally on Monday. But in Hong Kong, which is more exposed to the views of foreign investors, the Hang Seng fell, suggesting that doubts are creeping in about the willingness of Xi Jinping’s government — widely believed to prioritize fiscal conservative policies and issues of national security above economic growth — to follow through on spending the amount of money required to reinvigorate growth.

“The deflation threat is clearly growing,” wrote analysts from ING about the latest data. “But if we have a strong enough fiscal stimulus push, it should be sufficient to ensure this weakness is relatively short-lived.”

Answering that “but if” will be key to determining whether the recent world-beating performance of Chinese stocks continues.